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The Worst Stock for 2007: PolyMedica

It all depends on what the definition of free cash is.

The worst stock for 2007 is a small-cap cash generator in a growing market that has successfully overcome the taint of past scandals with new, experienced management, and sold off non-core assets to focus on its main lines of business.

What?

Yes, my nomination is a little different from some of the other dreck being panned in this tournament today. I'll state flat out that there are lots of companies far worse than diabetes-testing supply provider PolyMedica(NASDAQ:PLMD), most of them hanging out on the lesser exchanges or firmly entrenched in penny-stock land.

So why PolyMedica? I view the diabetes space as, sadly, a growth opportunity. But I'd probably rather chase makers of synthetic insulin, such as Sanofi-Aventis(NYSE:SNY) or Lilly(NYSE:LLY). My beef with PolyMedica lies more in that it has misled investors for years and doesn't deserve its premium valuation.

Aggressive accountingThe first problem with PolyMedica is that it isn't making as much money as it would like you to believe. Certain advertising expenses that a company uses for long-term customer attraction and retention can be capitalized and spread over an extended time frame. PolyMedica uses this method; one of its largest expenses is for what is known as direct-response advertising (DRA). In the trailing 12 months ended Sept. 30, PolyMedica spent $55.6 million on DRA, but only $45.7 million of it was amortized (expensed) on the income statement -- an amount representing small chunks of prior years' DRA expenditures. Thus, pre-tax profit gets a nearly $10 million boost. It's an acceptable, but aggressive, form of accounting.

I can hear the cries from the true believers now, "Not this again! Everybody knows about DRA; it's factored into the price already! Get over it!"

Sure, no problem.

Misrepresentation or spin? You decide.Accounting as it relates to earnings isn't the only issue. There's a little matter of cash flows, too.

In the past year and a half, PolyMedica has repurchased nearly 20% of its outstanding shares, financed first with variable-rate debt and since partially exchanged for potentially dilutive convertible debt. (But don't worry -- management has set up a complicated hedge to keep dilution in check.) The total interest burden from the debt is around $7.6 million annually.

PolyMedica also pays a $0.60 annual dividend, which represents a further $13.5 million claim against the company's cash flows. So debt and equity investors in the company are expecting around $21 million in outflows annually. But this is not a problem, because PolyMedica reports its free cash flow (FCF) -- supposed cash left over after all of the bills are paid, and all reinvestments in the business are made -- with every quarterly investor presentation. Its touted FCF record is $23.2 million, $37.8 million, and $51.4 million in each of the past three fiscal years. On a trailing-12-month basis, it claims $60.3 million in FCF. It's spinning off plenty of cash.

So, what am I worried about?

Well, look at the most recent presentation. (Link opens a PDF file.) PolyMedica seems to have forgotten that it pays taxes, which are definitively not free cash. And they've also ignored that a growing business (which they claim to be) needs to invest in working capital -- the equivalent of cash in the wallet for the day-to-day operations of a business. And over the past six quarters, working-capital management has stumbled.

Bringing in the increases in working capital and taxes, real FCF for the past three fiscal years is $5.4 million, $13.2 million, and negative $4.3 million. For the trailing 12 months, it's negative $21.3 million -- and anyone who would like my calculation spreadsheet, please email me.

Some may argue that since FCF is a non-GAAP measure, the company can define it however it wants. To that I say, sure -- call payments to the tax man whatever you want. But it's a fact that PolyMedica is not producing cash from its growing business, is financing its growth with ever-increasing debt (it has gone from net cash of $75 million to net debt of $258 million in six quarters), and is claiming cash generation to the contrary. I call that misleading.

A not-so-great business at a steep priceBoth of PolyMedica's business segments have little pricing power -- Medicare dictates pricing. We've already seen the company lose grip of its working-capital management. A recovery there should at least boost FCF back to the positive side. But I predict a guidance miss coming. The company guided for $1.47 to $1.58 in GAAP earnings for fiscal 2007, and at the midpoint, it sits at $0.59. Similarly, it expected cash flow from operations to clock in at $65 million to $75 million in fiscal '07, but six months in, it's at only $21 million.

Even assuming it can rein things in and start generating some real FCF, the price is simply too high. My 20-year discounted cash flow model, predicting robust sales growth, a strong turnaround in working-capital management, and no guidance misses can't be coaxed much above a $24 fair value. With the current stock price nudging $40, I have to say Danger! Horror! Get out!

The Foolish conclusionI think PolyMedica qualifies as the worst stock for 2007, but let us know what you think in our new Motley Fool CAPS community-intelligence database. Rate Polymedica to underperform. (I have.) Or if you disagree, rate it to outperform. Either way, make your voice heard. Based on your responses, we'll declare 2007's worst stock early next week.

Want to go back to the beginning of our Worst Stock for 2007 tournament? Right this way.